What Is an Inverted Spread?
An inverted spread is a type of yield spread. In general, a yield spread refers is the difference between the quoted rates of return on two different investments, usually of different credit qualities but similar maturities.
An inverted spread occurs when the yield difference between a longer-term financial instrument and a shorter-term instrument is negative. In other words, when a shorter-term instrument yields a higher rate of return (RoR) than a longer-term instrument, it is referred to as an inverted spread. An inverted spread is calculated by subtracting the longer-term instrument from the shorter-term instrument.
- An inverted spread occurs when the yield on a short-term financial instrument is greater than that of a long-term one.
- This spread is calculated by subtracting the long-term yield from the short-term yield.
- Investors expect longer-term instruments to pay more because they're required to keep their money in for a longer period of time.
- When short-term yields are greater, it indicates that investors are losing confidence.
- Short-term yields that are larger than long-term on U.S. Treasury bonds often indicate a recession is looming.
Understanding Inverted Spreads
An inverted spread can be contrasted to more typical market conditions, where longer-term instruments yield higher returns in order to compensate for time.
The yield on long-term financial instruments generally tends to be higher than short-term ones. For instance, 10-year U.S. Treasury bonds yield a higher return than two-year bonds. But there are situations that arise when the reverse occurs: The yield on short-term instruments is higher than long-term ones. For example, if two-year U.S. Treasury bonds yield more than 10-year U.S. Treasury bonds, it is known as an inverted spread.
For investors, it is safe to assume that shorter-term instruments have a lower yield, but investors expect a higher yield when their money is tied up for a longer period of time. A higher yield could be conceived of as the payoff for an investor being willing to commit their resources for an extended period of time. For this reason, inverted spreads are considered undesirable.
The yields of U.S. Treasury notes are often the most obvious—and the easiest—to track and compare. Investors might decide to contrast the yields of notes on the shorter end of the maturity spectrum, such as those with one-month, six-month, or one-year terms, against those with terms of longer durations, such as 10-year bonds.
To determine the spread between two different financial instruments, subtract the long-term yield from the short-term one. Once you've determined the yield spread between the instruments (using simple subtraction), you can identify whether it results in an inverted spread.
An inverted spread can be a red flag for a recession; in particular, investors and economists pay particular attention to inverted spreads between short-term and long-term U.S. Treasury notes and/or bonds.
Inverted spreads generally indicate that investor confidence in the short-term outlook is dropping. In fact, every major recession in the United States since the year 1950 has come after the market experienced inverted spreads.
Investors may feel more comfortable with the prospect of longer-term instruments and are usually less anxious to invest in short-term securities. As a result, issuers must offer a higher yield as a way to attract investors and motivate them to overcome their feelings of trepidation. Otherwise, many investors would instead just opt to go with longer-term bonds.
Example of an Inverted Spread
Suppose an investor has a three-year government bond yielding 5% and a 30-year government bond yielding 3%; the spread between the two yields would be inverted by 2% (calculated by subtracting the 3% yield from the 5% yield).
There are many factors that can cause an inverted spread.
and can include changes in the supply and demand of each instrument and the general economic conditions at the time.